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Wednesday, May 6, 2015

Cellcom

Cellcom Israel (CEL) has traded on the NYSE for more than 8 years, but it's price has never been so low. It is the cell network market share leader in Israel, but a price war is bringing down the industry's profits.

The company has an enterprise value of about $1.2B against operating income of $170 million, for an EV/EBIT of around 7. Because of the industry competition, revenue has been declining and will likely continue to decline this year: customers are taking advantage of the price war by renewing their cell phone contracts at lower rates.

However, Cellcom is not just the market share leader but also the margin leader, so I would expect them to survive these tough times and benefit when the industry returns to normal. Already, there are signs that perhaps the wars are beginning to end. Network providers have begun to form partnerships with each other in order to share costs, for example. Cellcom has also shown a remarkable ability to cut costs; the company's operating income actually rose in 2014 versus the prior year despite the decline in revenue.

Cellcom is also leveraging its large number of customers by attempting new forays into television and other media which could grow into valuable businesses in the future. In the meantime, as uncertainty in its core business hangs over the industry, investment rates in network upgrades have slowed. As a result, the free cash flow accruing to the company is much larger than its EBIT would imply. Last year, the company earned free cash flow of over $300 million, which covers its interest requirement 6 times; compare the free cash flow to its current market cap of just $460 million, and you can see why I like the stock!

Last year's free cash flow did benefit from positive working capital adjustments of $100 million or so, so I wouldn't expect this level to be sustained. But even if you take a grim view of what the price war will do to the company in the near-term, the free cash flow multiple still doesn't make sense. Though competition may be fierce at the moment, there are barriers to entry in this industry as it's difficult to generate profits without a full network, and difficult to finance and build out a full network without profits! I'm therefore banking on the fact that the current players won't irrationally hammer themselves down to zero. When industry conditions normalize, I'd expect the most profitable of the bunch (i.e. Cellcom) to be just fine and to benefit from higher multiples, a return to revenue growth and lower debt levels as current free cash flow is being used to reduce enterprise value.